There have been big moves in long-term interest rates in recent weeks and there is no consensus on what is causing this spike. In September the 10-year US Treasury yield increased by 0.5%, which is a big one month move given that the Fed appears to have stopped raising interest rates for now and inflation is declining.
Long-term rates typically respond positively to expectations of rate rises and inflation expectations, in other words, if inflation is rising and interest rates are going up, you would expect the bond market to respond with higher yields on longer dated debt to reflect higher expectations of future rates and inflation levels. Last month’s rise in longer term yields is therefore especially interesting for us to understand, given the opposite has been happening with interest rates (rate rises on pause) and inflation (coming down).
This increase in longer dated yields has had a negative short-term impact on equity markets. Higher yields in 10-year US treasuries makes them more attractive as an investment and so encourages more capital to flow into those securities, at the expense of equities and other asset classes. Valuations of stocks are also reliant on applying a ‘discount’ rate to future cash flows. Higher discount rates reduce the present value of future cash flows and so, in theory at least, should result in a lower share price today. September was a weak month for equity prices.
An important question to ask is: why is this happening now in bond markets?
One explanation might be that the bond market is changing its expectations as to what future interest rates will be. If expectations for what rates will be in the future rise, this should translate into higher longer-term yields. This explanation for the recent spike in long-term yields is attractive, given how simple it is, but it is also in our view an over-simplification. There is little new information to support a sudden change in expectations in bond markets about where future rates will be.
Another explanation would be a jump up in future expectations for inflation. If markets think that future rates of inflation will be higher than previously expected, this should be reflected in higher longer-term yields. Again, this is an attractive explanation, but this isn’t supported by any new information on inflation, which continues to decline.
The final explanation is the one we think is most interesting. Perhaps, the bond market is caching up to where the equity market was earlier this year. If economic growth rates in the future end up being higher than expected, you might expect longer term yields to rise to reflect this. Markets discount future expectations so if, under the surface, bond market expectations are becoming more bullish about future rates of economic growth, you would expect to see the move up in longer term yields we have seen recently.
This fits with our view that the underlying economy may be in better shape than many people think, inflation may be in the rear-view mirror, interest rates likely will come back down and real rates of economic growth will accelerate. New innovative technologies like AI could further support improvements in economic productivity and as such, equity markets could be on the cusp of a strong bull market up-cycle. This view is far from the consensus right now, but as we have previously written, we see interesting parallels with this current inflation and economic cycle to that of the late 1940s, characterised by a pattern of high inflation followed by lower inflation and a strong equity market rally. Short-term bouts of market weakness, if we are right, would be an opportunity to buy.